The Limitations of Bitcoin

Much has been written about the benefits of cryptocurrencies, such as bitcoin and blockchain technology. Without a doubt, blockchain technology will revolutionize the world. While we recognize the value of cryptocurrencies and blockchain technology, we should go beyond the bitcoin fashion and understand the obstacles these technologies face, in order to recognize the opportunities they offer.

The Bitcoin Mania

We can summarize a list of psychological biases that explain why bitcoin followers blindly fall in love with this technology, underestimating many of the challenges it poses:

Confirmation bias.

Bandwagon effect

Ostrich effect

Pro-innovation bias

Etc.

This leads some followers of bitcoin to ignore the difficulties they may face in the future. Although some get carried away by these biases, the potential of bitcoin and blockchain technology is undeniable.

If you have ever made an international transfer, you will have realized that the international payment industry is the one that most needs change; transactions take days, lack transparency, and often fail. Intermediaries are plentiful and costs are high. Currency exchange is expensive. Each year, around $300 trillion are produced in international transactions, providing bank revenues of between $150 and $200 billion. It is an industry that will be disturbed by financial innovation.

The Doubling of Bitcoin

What are the problems in bitcoin paradise? Two serious ones actually. As the volume of transactions in bitcoin increases, the blockchain becomes longer and longer. Over the years, a large number of transactions have accumulated and this has led to:

Longer transaction times: Currently, it takes nearly four hours to process a transaction. As the volume increases, transaction times will increase.

Higher Transaction Costs: To get faster transactions, that is, to get priority over other transactions in the verification process, the bitcoin user can offer a payment. As transaction history only grows and transaction times are increasing, users are forced to offer payments for faster transactions. Currently the cost is $ 0.32 per transaction

All this is worrying, since the main advantage of cryptocurrencies is that the transactions are resolved in real time and at costs lower than the traditional transactions. Bitcoin enthusiasts (for lack of a better term) dismiss these issues as irrelevant, often unable to recognize that these problems will only worsen, not improve.

One of the solutions is simply to allow an increase of transactions by “block”. Currently 11% of bitcoin miners support this solution (since they installed the modified blockchain software). As soon as they become more than half, there will be a “doubling of bitcoin”. This would mean that a bitcoin would be divided into two different bitcoin coins: Bitcoin Core (the classic bitcoin), and Bitcoin Unlimited (modified bitcoin). To allow such an increase in the blocks, would mean compromising the security of the protocol.

Longer Transaction Times

The bitcoin blockchain is too long, even if more transactions per block are allowed. The real problem is that blockchain gets bigger and bigger, since all historical transactions are recorded in it (like blocks). In fact, this is one of the fundamental problems of the technology in general.

Ripple, for example, a competitor (or a complement as some would say), is not based on a blockchain, but on a distributed ledger. In this distributed ledger, only current transactions, not all historical transactions, are recorded. This prevents process times from getting out of control. Bitcoin, as it currently exists, is unable to support a volume of transactions even close to the total volume of global transactions.

Ripple does not prevent the nodes (the bitcoin miners’ equivalents) from storing their own historical records to, for example, improve the customer experience. However, Ripple thinks there is no reason to distribute these records throughout the transaction validation network.

Higher Transaction Costs

As we approach bitcoin emission limits (the limit is 21 million units and there are currently 16 million bitcoins in circulation), mining bitcoins is becoming less profitable. Even though it is possible that the price of bitcoin will increase significantly and/or computing costs will fall, we will reach a point where mining bitcoins will no longer ignite interest. The result is clear: miners will lose interest, nd provide less computing power to process transactions.

What is the solution?

Bitcoin users will have to incentivize bitcoin miners by offering transaction fees like an auction, or bitcoin has to be reformed to allow for a growing bid.

Even with a “bitcoin doubling”, transaction costs will get out of control, or the upper limit of emissions should increase (some propose to increase bitcoin supply by one or two per cent per year indefinitely). Either way, buying bitcoin as an investment is risky as it involves speculating on some kind of favorable outcome in terms of fundamental changes in the bitcoin protocol. These changes in the protocol are almost unanimous. There is a high probability that any decision will turn out to be bad in the future of bitcoin.

The most important limitation of the blockchain

One limitation to blockchain or distributed ledger technology that is rarely discussed, is counterparty risk. Some bitcoin evangelists seem to ignore the fact that any asset traded through bitcoin’s blockchain -except for the bitcoin itself- inherently suffers from counterparty risk.

When blockchain technology is used to carry out transactions of other assets (financial or physical), an IOU of that asset is being transacted. The IOUs have counterparty risk, and if there is no mechanism to prevent or mitigate this type of risk, blockchain technology will never end. Transferring an IOU from person A to person B is not a problem; Transferring the promised asset to person B from person A is.

Those who are stand to gain are likely to recognize the limits of blockchain technology and address these challenges. It seems that there are initiatives that address these issues, such as Ripple and Ethereum (blockchain for smart contracts).

We suspect that bitcoin, despite being a pioneer, faces the same fate as Napster: staying as an old memory, taking their revolutionary spirit and pioneer to their own grave.